2. Master Objectives
Investment and Opportunity Cost
Debt Cycle
Financial Institutions and Intermediation
Financial Instruments
Portfolio Theory
Active Investment Management
Financial Crises
3. Financial System
Purpose: bring together individuals, businesses, and
government entities (economic units) that generate
and spend funds.
Surplus economic units have funds left
over after spending all they wish to spend.
Deficit economic units need to acquire
additional funds to sustain their
operations.
4. Financial Markets
Classified according to characteristics of participants
and securities
Primary Market: deficit economic units sell securities to
raise funds.
Secondary market is where investors trade previously
issued securities with each other.
Other types of Markets, e.g. Money and Capital
Markets
5. Financial Markets
Money Market
Trade short term (1 year or less) debt
instruments (e.g. T-Bills, Commercial Paper)
Major money centers in Tokyo, London and
New York
Capital Market
Trades long term securities (Bonds, Stocks)
NYSE, ASE, LSE, over-the-counter (NASDAQ
and other OTC)
6. Financial Markets
Intermediaries, such as commercial and investment
banks and insurance companies facilitate the flow of
funds in the financial marketplace. This called
“Financial Intermediation”.
$$ Securities
Securities $$
7. Market Efficiency
Market efficiency refers to the ease, speed, and
cost of trading securities.
The market for the securities of large
companies is generally efficient: Trades can
be executed in a matter of seconds and
commissions are very low. Somewhat true: rule
generally is still T+3.
The real estate market is not generally efficient:
It can take months to sell a house and the
commission is 6-7% of the price.
8. Market Efficiency
Why is market efficiency important?
The more efficient the market, the easier it
is to transfer idle funds to those parties that need the
funds.
If funds remain idle, this results in lower growth for the
economy and higher unemployment.
Investors can adjust their portfolios easily
and at low cost as their needs and preferences change.
9. Securities in the Financial Market
Money Market Securities
Highly liquid, low risk
Treasury Bills (T-Bills)
Certificates of Deposit (CDs)
Commercial Paper
Eurodollars
Banker’s Acceptances
10. Treasury Bills
T-Bills are short term securities issued by the
Federal Government [USA].
After initial sale, there is an active secondary market.
They are bought at discount and at maturity face
value is paid.
11. Negotiable Certificate of Deposit
Interest bearing securities issued by financial
institutions.
Maturities of one year or less.
12. Commercial Paper
Unsecured debt issued by large corporations with
good credit ratings.
Usually bought only by large institutions.
13. Eurodollars
They are dollar denominated deposits located in
non-US banks.
Buyers and sellers are large institutions.
14. Banker’s Acceptances
Debt securities guaranteed by a bank.
Used primarily to facilitate international
transactions, e.g. International trade.
15. Bonds
They are “IOUs” issued by the borrower and sold to
investors.
Issuer promises to pay the face amount of the bond
on the maturity date, plus pay interest each year in
the amount of the coupon rate times the face value.
How many “cash flow” streams does a bond have?
Other types
Treasury bonds issued by Federal Government
Municipal bonds issued by state and local governments
Corporate bonds
16. Common Stock
Shareholders own a portion of the company and
have right to vote on major decisions
Return on investment: dividends [if paid by company]
and capital gain, if any.
17. Preferred Stock
Hybrid instrument between bond and common stock.
Accounting purposes, it is equity, not debt.
Dollar value is guaranteed
Dividends paid to preferred shareholders first under
contract
Rarely have voting rights
In event of insolvency, paid off after bondholders but
before common shareholders
18. Interest Rates
Interest Rates Determined by
Real Rate of Interest
Expected Inflation
Default Risk
Maturity Risk
Liquidity Risk
19. Real rate of interest
Compensation for lender’s lost opportunity to
consume.
20. Default Risk
For most securities, there is some risk that the
borrower will not repay the interest and/or principal
on time, or at all.
The greater the chance of default, the greater the
interest rate the investor demands and the issuer
must pay.
21. Expected Inflation
Inflation erodes the purchasing power of money.
Example: If you loan someone $1,000 and they pay it
back one year later with 10% interest, you will have
$1,100. But if prices have increased by 5%, then
something that would have cost $1,000 at the outset of
the loan will now cost $1,000(1.05) = $1,050.
22. Maturity Risk
If interest rates rise, lenders may find that their
loans are earning rates that are lower than what
they could get on new loans.
The risk of this occurring is higher for longer
maturity loans.
Lenders will adjust the premium they charge for this risk
depending on whether they believe rates will go up or
down.
23. Liquidity Risk
Investments that are easy to sell without losing
value are more liquid.
Illiquid securities have a higher interest rate to
compensate the lender for the inconvenience of
being “stuck.”
24. Determination of Rates
k = k* + IRP + DRP + MP + LP
k = the nominal, or
observed rate
on security
k* = real rate of
interest
IRP = Inflation Risk
Premium
DRP = Default Risk
Premium
MP = Maturity Premium
LP = Liquidity Premium
25. Term Structure
Relationship between long and short
term interest rates
Yield curve
28. Financial versus Real Assets
Essential nature
Reduced current consumption
Planned later consumption
Real Assets
Assets used to produce goods and services
Financial Assets
Claims on real assets
29. Investment Process
Asset Allocation
Security selection
Risk-return trade-off
Market efficiency
Active vs. passive management
30. Active versus Passive Management
Active Management
Finding undervalued securities
Timing the market
Passive Management
No attempt to find undervalued securities
No attempt to time
Holding an efficient portfolio
31. Financial Engineering
Repackaging Services of Financial Intermediaries
Bundling and unbundling of cash flows
Slicing and dicing of cash flows
Examples: strips, CMOs, dual purpose
funds, principal/interest splits
